A recent Wall Street Journal article highlighted how sketchy brokers have been marketing problematic private placements to accredited investors. While the article focused on the brokers, I was struck by the identity of one of the investor victims noted in the article as having lost a lot of money: George Stephanopoulos, the ABC News anchor and former Clinton Administration official. I don’t mean to cause Mr. Stephanopoulos any further embarrassment by highlighting this here (though I’m guessing that the readership of my blog is far less than that of the Journal), but the fact that he was scammed is a useful illustration of the misguidedness of the accredited investor definition and associated rules.

The current definition of “accredited investor” under SEC rules essentially uses wealth as a proxy for sophistication, as an individual can qualify by either having an annual income of $200,000 or a net worth of $1 million not including the value of one’s primary residence. An offering made to all accredited investors does not have an information requirement, meaning the investors do not need to be provided with a similar level of disclosure that would be associated with a registered public offering.

Back when the equity crowdfunding rules were proposed following passage of the JOBS Act, the $1 million offering limit per year for what are now known as Regulation CF offerings was viewed as making this procedure impractical. The amount raised would not be sufficient in light of the legal, accounting and other costs needed to prepare for the offering. However, as crowdfunding is now a reality and companies are giving it a shot, a fix to the dollar limit has evolved: raise funds not just under Regulation CF, but under other exemptions that are not subject to that dollar limit.

Ernest Holtzheimer blogs with some statistics about how the new JOBS Act-authorized forms of securities offerings are being used following enactment. Both the revamped Regulation A and new Regulation Crowdfunding have seen somewhat underwhelming use to date. The most common objection to Regulation Crowdfunding, the $1 million offering limitation, has led companies to consider using Regulation A, which is more involved compliance-wise. Legislation to increase the offering cap for Regulation Crowdfunding might have a better chance of enactment with the coming all-Republican government, with its anti-regulatory bent. Of course, companies that are willing to limit their investor base to all accredited investors aren’t subject to the offering limit.

Holtzheimer mentions an advantage of crowdfunding that is less remarked-upon than some others: that crowdfunding can help save company founders time, as compared to more traditional forms of investment like angel investment and venture capital. Traditional capital-raising involves spending an enormous amount of time with potential investors, explaining the business, responding to due diligence requests, etc. In addition, when there is an investor syndicate rather than just one investor, the different members of the syndicate may have different requests/concerns, so the process is like herding cats. In contrast, at least in theory, with crowdfunding and Regulation A, once the proper disclosure is prepared and posted for investor review, the investors make their choices, and if there’s enough interest, you just go ahead and close.

The effectiveness of Title III crowdfunding got the high-profile Sunday New York Times treatment this past weekend. I think it will take some time for the flow of these deals to come, as portals apply for and receive approval from the SEC and the overall infrastructure develops.

The Times article has a quote from a Mintz Levin securities attorney expressing skepticism and noting that unlike venture capital investing, crowdfunding does not provide institutional validation of a company. I would agree that it doesn’t, but at the same time, it shouldn’t be considered a red flag. Because of the $1 million per year offering limit currently applicable to Title III crowdfunding, this route will only make sense if the business can execute its plans with those kind of funds. Capital-intensive ventures, like those in the life sciences industries, will likely continue to need venture funding. But for those who don’t, even if they don’t get the external validation of an institutional investment, they can get the funds they need to operate relatively easily and without the onerous terms often imposed by venture investors.

The article closes with an interview with a potential crowdfunding investor who said she skimmed the offering circular but says she’s financially sophisticated enough to take the risk. (The offering circular, which is linked to in the article, is actually for a Regulation A+ offering, not Title III crowdfunding.) Much of the commentary about risks for fraud in recent years has focused on Title III crowdfunding, rather than other JOBS Act initiatives, like Regulation A+, but ironically it’s only Title III crowdfunding that has the strict investment limits imposed on investors with low net worth or income, which protect them from being wiped out. The investor profiled in the Times may well lose a lot of money on her Regulation A+ investment (as she could, as well, by investing in a public company), but she’d automatically limit her risk exposure by sticking to Title III crowdfunding offerings only, because of these limits.

Professor Andrew A. Schwartz writes in Harvard’s corporate governance blog about the likelihood of success of soon-to-be implemented Title III crowdfunding. Relative to much commentary on this topic, Professor Schwartz is an optimist about the potential of crowdfunding to overcome some of the risks of investing in entrepreneurial ventures. While I am too for some of the reasons he cites, I’m not sure about one of them: that the “wisdom of the crowd” will lead to better investment decisions than would be made by individuals or small groups, even experts.

Under the right conditions, the wisdom of crowds can be quite powerful, as described in New Yorker columnist James Surowiecki’s excellent book called, well, The Wisdom of Crowds. Does the principle apply in the crowdfunding context? Imagine a crowdfunding portal where instead of being able to choose some or none of the available investment opportunities, investors were forced to assess Company A and Company B and pick one of the two to invest in. Under those (unnatural) circumstances, I would expect the crowd to make the right decision, meaning the company that attracts more investors would be the better investment opportunity.

However, that’s not how a crowdfunding portal will work. Instead, an essentially unlimited pool of potential investors will scan the available opportunities and make a yes or no decision about each one. Suppose that a company seeks to raise $500,000 through a crowdfunding portal. 5,000 potential investors review the offering. 4,500 of them decline to participate, and most of them think it’s a terrible, laughable business concept. The remaining 500 like it and each decide to kick in $1,000. So in this scenario, you have a large majority having a bearish view of the company, and yet it successfully raises its full offering. In other words, the immense size of the potential investor pool could lead to bad companies successfully raising capital.

To be sure, there are plenty of bad investments made today, in the pre-crowdfunding world, so crowdfunding will not usher in a new era of good money chasing bad investment ideas. That’s been happening for as long as there’s been investment. I’m just skeptical that we can conclude that a company that completes a crowdfunded offering has been somehow vetted as a result of its approval by the crowd.

Press Coverage

"Andrew Abramowitz, a lawyer in Manhattan who has worked with both buyers and sellers of private placements, said every investor should approach a private placement skeptically." -- Paul Sullivan (New York Times)

"If the goal [...] is to protect people from losing all of their money in an illiquid investment, the current standard fails on that count, too. Andrew Abramowitz, a lawyer in Manhattan who has worked with both buyers and sellers of private placements, said a better standard might be to limit how much of their net worth people can invest." -- Paul Sullivan (New York Times)